Obama’s Big Chance

Albeit reluctantly, the Senate gave the go-ahead to release the additional $350 billion in TARP funding contemplated by the original plan. A 52-42 vote isn’t exactly a resounding vote of confidence, but who can blame the Senators for their cynicism given the manner in which the first $350 billion was disbursed and the utter lack of tracking and accountability? The representative case for support was articulated by Senator Richard Durbin:

“It’s money that can be spent, may be spent, by the new president, Barack Obama ,” Illinois Democrat Richard Durbin said before the vote. “I want to give President Obama the tools he needs to breathe life back into this economy.”

To his credit, President-elect Obama acknowledged that this vote was a struggle because of the widespread displeasure over the handling of TARP I:

“I know this wasn’t an easy vote because of the frustration so many of us share about how the first half of this plan was implemented,” Obama said in a statement. He promised to set strict pay limits on executives at companies receiving funds, provide more loans to small businesses and ensure “taxpayers can see where their money is spent.”

The question is, will Obama yield to populist rhetoric and Congressional photo-ops or will he do the ugly work that needs to be done? What worries me are intentions such as these:

To overcome political objections, the incoming Obama administration pledged to spend $50 billion to $100 billion on a “sweeping” foreclosure-prevention effort. It also said it would impose tougher restrictions on banks that receive government aid, including requirements on banks to lend money, increased restrictions on executive compensation and curtailed dividend payments for some firms.

I’m not sure what a “sweeping foreclosure-prevention effort” is, but it worries me. Requirements for banks to lend money? A really, really bad idea. While some of the badness that happened over the past 5-7 years led to distorted markets, e.g., abnormally cheap credit, instruments that received high ratings inconsistent with their risks, fraudulent loan origination practices, etc., coming in and distorting them further is not a recipe for a healthy recovery. Plenty of people directly and indirectly hold mortgages that were originated in an honest manner but whose payers either can’t or don’t want to service their debt. Should they be penalized because the servicer wants to foreclose and/or the payer no longer wants to fulfill an obligation on a house with no remaining equity? The incentives are perverse, and the ripple effects of a wholesale mortgage restructuring project would be far-reaching and re-distribute wealth in potentially unfair and inappropriate ways.

Forcing banks to lend couldn’ be a more intellectually bankrupt idea. The business of commercial banks is to lend money when the risk-adjusted returns exceed its cost of capital. Just lend money, because we said so? We’ve seen this movie before – it’s called Fannie Mae and Freddie Mac – and it doesn’t end well. The right way to approach the problem is to create truly healthy banks, either out of currently sick institutions or de novo, and to let them make rational lending decisions. If the Government sees a particular constituency that requires funding, don’t force a bank to do it if it doesn’t make economic sense. Either create a discrete program or use tax incentives to generate the necessary resources. The worst possible outcome of TARP is to create another generation of sick institutions by forcing them to make irrational loans to satisfy the moral (or public relations) objectives of our Government representatives. Obama needs to fight this urge with a vengance.

Then there is the issue of using TARP for non-financial sector problems – like the auto industry. In order to ensure support from the Senate, Larry Summers, the future head of the National Economic Council, made the following remarks:

In a nod to concerns about how the bailout has expanded beyond financial firms to include the U.S. car business, Mr. Summers said the second half of the funds would be used to help prevent “systemic consequences in the financial and housing markets,” not to implement an “industrial policy” that would aid various troubled industries. To assuage Republican concerns, the Obama team also agreed to provide additional support to the auto industry only “in the context of a comprehensive restructuring.”

This is good news. There is TARP and there is industrial policy, and there is good industrial policy and bad. Lobbing cash into a sick auto industry without a comprehensive approach to the problem is bad policy. Bad like TARP has been bad, providing sick institutions with cash without fundamental changes in their businesses, management, or the promise of an appropriate risk-adjusted return. Fortunately Mr. Summers is smart enough to know this, and he will hopefully keep Obama from veering off course.

How Obama handles the financial crisis over the next 180 days will set the tone for his entire Administration. He needs to be a strong, pragmatic, independent thinker who refuses to be swayed by headlines or popularity contests. He needs to earn the respect – not the love – of the US citizenry. This means making decisions for the long-term good of the country, even if it means incurring excruciating short-term pain. Palliatives are the easy way out; set rates to zero, pump additional trillions of liquidity into the economy, restructure all non-performing mortgages of people below a certain income threshold, bail out dying industries that employ hundreds of thousands of workers, support local public-works projects, and watch our country slide by on his watch and then absolutely crater after he leaves office. Many would choose this course because, well, it doesn’t require much imagination or tolerance for pain. But it is the wrong thing to do.

Obama has the potential to be the most impactful President in generations if only he has the intestinal fortitude to do the hard work and to make the hard decisions required. Forces will conspire to push him off this path. He must resist them.

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